ARMs helped sink the economy - now they're back!

By Les Christie, staff writerMarch 22, 2011: 11:19 AM ET

NEW YORK (CNNMoney) -- Adjustable rate mortgages are back!

After accounting for nearly 70% of all mortgages issued during the boom, ARMs vanished during the bust, totaling just 3% of the market in 2009. Now they make up 5% of all mortgages issued, and Freddie Mac predicts 10% by December.

"For anyone with a high likelihood of moving soon, the 5/1 is a great product," said Michael Fratantoni, vice president of research and economics for the Mortgage Bankers Association. "It's a well understood product too; there's not a lot of danger with it."

So why isn't everyone grabbing an ARM?

Well, because fixed-rate mortgages are seen as safer because they carry the same rate over life of the loan. Borrowers always know what their payment will be.

But with ARMs, interest rates change over time. For example, the 5/1 ARM -- the most common loan -- has the 3.5% introductory rate for the first five years. After that, the rate adjusts annually.

That sounds kind of dangerous, but look deeper. On a $200,000 mortgage, the monthly ARM payment at 3.5% would be $898 compared with $1,074 for a 30-year, fixed-rate loan at 5%.

That's a $10,560 difference after five years, when the ARM would adjust. At that point the ARM rate could jump to a worst-case scenario 8.5% and the monthly payment to $1,538.

It would still take more than 22 months of the higher ARM payments to offset the first five years of savings.

"Even under a worst case scenario, you're better off with an ARM if you're planning to live in the house for less than seven or eight years," said Steve Habetz, a loan officer with Darien Rowayton Bank in Connecticut.

And, the reset will, most likely, be lower than to 8.5%. The amount the rate can increase is typically calculated by adding a margin of 2.75 points to an index, usually the rate of a one-year T-bill, explained mortgage broker Alan Rosenbaum, founder of GuardHill Financial. And most loans have a maximum amount they can rise per year and a cap on how high the rate can go.

Still, many homebuyers want no part of ARMs.

"I had a client recently who told me that they were going to move in four or five years," said Habetz. "I suggested an ARM. They insisted on a fixed rate. It made no sense but that's what they wanted."

Many buyers remember the so-called toxic or exploding ARMs and how their defaults triggered the mortgage meltdown, helped sink the housing market and usher in the Great Recession.

These loans failed for a couple of reasons. Many were issued to people who lacked the income to pay once the initial years of low fixed rates ended and the interest rate reset higher. Too, the caliber of borrowers was very low.

The 5/1 is an entirely different animal, experts says. Unlike the toxic ARMs, these products are issued to borrowers with high credit scores, making substantial down payments and with assets, debt and income carefully underwritten before approval.

Rosenbaum said he's always featured the 5/1 ARM as the product of choice unless the clients tell him they're planning to live in the home for 15 or 20 years.

For people planning to stay for less time, "It's paying for insurance they don't need," he said.